Should You Be Worried If You’re Long?

Find out how Dow Theory applies to the current market

On Friday, high net borrowings by Spanish banks from the European Central Bank, disappointing economic data from China, and a shortfall in the Michigan Consumer Sentiment sent stocks lower. It was the sixth decline in eight days and the biggest weekly decline of the year. Losses occurred last week despite excellent earnings from Alcoa (NYSE:AA), Google (NASDAQ:GOOG), JPMorgan Chase (NYSE:JPM) and Wells Fargo (NYSE:WFC).

Friday’s decline was led by the financial sector with Dow member Bank of America (NYSE:BAC) off 49 cents (5.3%). On Friday, the Dow Jones Industrial Average was off 137 points, closing at 12,850, the S&P 500 lost 17 points at 1,370, and the Nasdaq fell 44 to 3,011. The NYSE traded 770 million shares and the Nasdaq crossed 406 million. And decliners outnumbered advancers by about 4-to-1 on both exchanges.

The market is becoming more volatile (as evidenced by the VIX chart) despite the current low volume, and so if sellers decide that “enough is enough” they could flood the markets with liquidations. Pullbacks should first run into support at Tuesday’s and Wednesday’s lows at S&P 1,357 (green dotted line), Dow 12,754, and Nasdaq 3,000. And since those support areas are so close at hand and established with low volume, it wouldn’t take a lot of selling to penetrate them and flip the power back to the bears for the near and possibly intermediate (secondary) term.

With volume now at the lowest of the year and the markets in an odd state of bullish vulnerability, many are resorting to withdrawing from trading until either a new trend develops or the uptrend reasserts itself, and I think that’s a sound approach.

While we play the waiting game, let’s review a summary of several of my reports of the most widely followed technical analysis study ever devised: The Dow Theory.

Over the years, I’ve had clients question the use of a 125-year-old theory on current markets. Despite the fact that there is no single technique that investors should rely on at the exclusion of all others, this theory has stood the test of time. All modern technical analysis had its beginnings with Charles Dow’s theory, and understanding it will also help you decide whether you are a long-term investor, and intermediate-term trader, or a short-term, perhaps even day trader.

The Daily Market Outlook attempts to clarify the technical trends of the market for investors and traders alike — not always an easy task for both writer and reader. Thus, it may be helpful to consider Dow’s concept of three trends (primary, secondary and minor) in order for you to decide what type of investor you are.

The major (primary) trends are like the ocean’s tides — a primary bull market is like an incoming or flood tide, which runs farther and farther up the beach until it finally reaches a high-water mark before it begins to recede.

While the tide is coming in there are waves breaking on the beach — some incoming and some outgoing. While the tide is rising, each succeeding wave pushes a little farther up onto the shore and when the tide has reached its maximum height the waves recede, never quite reaching as far as their predecessors. The waves are the intermediate trends.

Meanwhile, the surface of the water is in constant agitation as wavelets and ripples move along with and against the major trend. The wavelets and ripples are analogous to the market’s minor trends and are unimportant day-to-day fluctuations to long-term investors but followed closely by traders.

The tide, waves, and ripples represent the primary (major), secondary (intermediate), and the minor (short-term) trends of the market.

Currently the tide is rising — we are in a bull market. And the waves (intermediate trend) are still incoming but becoming less aggressive. The wavelets are mostly going out, and so the near-term trend is sideways to down.

What is your investment goal or style? If you are a long-term investor you would welcome a pullback as long as the bull market continues. You should have a list of investment-grade stocks and the prices at which you would like to buy them.

As an intermediate trader you should be doing the same except that you will be more interested in fast-moving stocks and more geared to chart analysis of trendlines and support zones.

But as a short-term trader you should follow options premiums and other leveraged situations that will take advantage of the near-term ripples of the market, and be very sensitive to near-term support and resistance areas and volume. Currently, as a short-termer you should be concerned if you are long and should be on the sidelines or shorting into rallies.

Friday’s Daily Market Outlook, “Beware This ‘Too Good to Be True’ Rally,” was written mostly for the short-term and intermediate trader. But even traders should be aware of the overall direction of the market, which includes all three trends, since you’ll find that by trading with the overall trend your percentage of profitable transactions will rise.